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Rogue Trader Loses UBS $2 Billion

This article has been adapted from our sister site across the pond, Fool U.K.

With French banks taking a beating on fears of their exposure to eurozone debt, and the European Central Bank reporting a sharp rise in emergency funding this week, the last thing the banking sector needs is another rogue-trading scandal.

Oh, no, not again!Unfortunately, UBS(NYSE: UBS), the biggest bank in Switzerland, this morning admitted that a single rogue trader has run up an "unauthorized loss" of $2 billion (1.3 billion pounds). At 3.30am on Thursday, City of London police arrested a 31-year-old man on suspicion of "fraud by abuse of position."

As a result of this blow-out at its investment bank, UBS has warned that it could make a loss in the third quarter of 2011. What's more, this is only an estimated figure, so the final loss could be even higher.

Although no customer accounts were affected by this illicit trading, UBS shares are down 6% to 10.3 Swiss Francs as I write. In mid-February, UBS shares were around CHF19, so they have nearly halved (down 46%) in the past seven months.

A long line of rogue tradersOf course, this isn't the first time a European bank has been hammered by unofficial trades. In fact, this is merely the latest in a long line of rogue traders going back decades.

This Hall of Shame includes now-infamous figures such as Nick Leeson at British bank Barings (1995), Jerome Kerviel at French bank Societe Generale (2008), and John Rusnak at a U.S. bank owned by Allied Irish Banks (2002). I list more shockers in The world's worst trades.

Nevertheless, news of this "hidden" trade suggests that UBS is having problems with its risk management. This will dent its reputation in world markets, as well as enraging its shareholders. Also, the Swiss government will be livid, having bailed out UBS with billions of taxpayers' Francs in 2008.

Sudden swings, big lossesOnce again, this demonstrates that, despite tightening up their IT systems and compliance procedures, investment banks can still be "gamed" by determined, greedy, or reckless traders. Thanks to bad character, bad decisions, or bad luck, traders can and will lose billions.

Most often, such rogue trades emerge during periods of high market volatility, when sudden, large swings in asset prices can turn modestly profitable trades into thumping losses. Given the market volatility since late July, it was almost inevitable that at least one rogue trade would come to light.

(Market whispers suggest that the loss at UBS might well have been caused by a highly leveraged currency trade going the wrong way. If these rumors are right, then the chances are that such a trade might have involved the Swiss Franc, which abruptly reversed its upward trend in early August.)

Stopping "casino" bankingOn Monday, the Independent Commission on Banking, headed by economist Sir John Vickers, recommended that U.K.-based banks should be legally separated into their retail and investment-banking arms.

Under these proposals, systemically vital functions -- such as deposit-taking, granting mortgages and business loans, and payments systems -- would be ring-fenced so as to protect them from investment-banking losses.

Clearly, today's news from UBS lends yet more weight to the ICB's arguments.